Key person disability coverage can unlock (and protect) the big deal

When private equity professionals target a new portfolio company for acquisition, they face a myriad of risk. But for many investments, the single greatest exposure is the loss of key human capital.

While not an overwhelming factor in every transaction, some deals are burdened with stakeholders, founders and leaders that are critically tied to the brand and organizational success. When a dynamic human capital risk is identified, private equity professionals think of key person life insurance to transfer this risk and protect their investment. But that’s where most of them stop, leaving the largest exposure – the risk of that same individual being disabled – uninsured.

It’s often difficult to get across the idea that a key executive’s disability risk is many times greater than that of death during the first critical post-acquisition years, but statistically it is. A term life policy generally costs about one-third as much as key person disability coverage, and it should because the risk of death during the working years is far lower than the risk of disability. As the old adage goes, you get what you pay for. While ignoring the probability of disability may seem like a cost-saving opportunity, the odds may not be as favorable as they appear. In fact, the gamble is far less favorable than most of us may think. As it turns out, the Council of Disability Awareness (CDA) paints quite a different picture:

90% of us underestimate our chances of becoming disabled.

85% of us express little or no concern that we might suffer a disability lasting three months or longer.

56% of us don’t realize that the chances of becoming disabled have risen over the past five years.

Even in light of these findings, there are those who are still quick to dismiss the chances of becoming disabled as little more than scare tactics promoted by life insurance companies. The facts tell quite a different story, confirming that the chances of becoming disabled are far higher than we might think. Based on the findings of the CDA:

• A typical male, age 35, 5’10”, 170 pounds and a non-smoker who works in an office environment, with some outdoor activity, and who leads a healthy lifestyle has these risks: a 21% chance of becoming disabled for three months or longer during his working career, with a 38% chance that the disability would last five years or longer and with the average disability for someone like him lasting 82 months – nearly 7 years. If the same person used tobacco and weighed 210 pounds, the risk would increase to a 45% chance of becoming disabled for three months or longer.

• A typical female, age 35, 5’4”, 125 pounds and non-smoker, who works mostly an office job, with some outdoor physical activity and who leads a healthy lifestyle has these risks: a 24% chance of becoming disabled for three months or longer during her working career, with a 38% chance that the disability would last 5 years or longer, and with the average disability for someone like her lasting 82 months. If the same person used tobacco and weighed 160 pounds, the risk would increase to a 41% chance of becoming disabled for three months or longer.

As we might expect, there are factors that can increase a disability risk, such as excess body weight, tobacco use, high-risk activities or behavior, chronic conditions such as diabetes, high blood pressure, back pain, anxiety or depression, frequent alcohol consumption or substance abuse.

Based on the facts, it would seem appropriate for private equity firms to recognize the potential catastrophic effect that a disability event could have on their investment. Fundamentally, the risks are identical to investors in either the case of death or disability. Accordingly, the second step would be to mandate adequate company-owned key person disability protection on the CEO or other prime movers of the companies they acquire.Hiring the right CEO isn’t easy and when the need arises suddenly as in the case of disability, the situation is even more intense.

Also to be considered is that generally the success of companies being acquired tends to be closely tied to the CEO, who, more often than not, is the founder and visionary that drives its success. In addition, such companies are almost always lean, with few, if any, back-up personnel capable of stepping into the CEO’s shoes.

What’s at risk is enormous. Should the CEO be taken out of the picture suddenly, their investment is in danger and the company’s viability may well be put into serious question.